You have to go back to late 2007 to find another time in which the stock market was more overvalued than it is today, according to a unique dataset of high-quality dividend-paying stocks.
That came at the top of the bull market, you may recall, just prior to the Great Recession and the worst bear market in U.S. history since the Great Depression.
I draw this ominous parallel based on data calculated by an investment advisory service called Investment Quality Trends, founded in the 1960s by Geraldine Weiss and currently edited by Kelley Wright. Twice each month since the 1960s, the service segregates a group of several hundred dividend-paying blue-chip stocks into four categories based on where their yields stand relative to their historical ranges. (Full disclosure: This newsletter is one of the services that pays a flat fee to have its returns audited by my firm.)
One of the newsletter’s four categories—the Overvalued category—was found by my econometric tests to have statistically significant ability to forecast the S&P 500’s returns. A lower percentage of stocks in that category is correlated with higher subsequent stock market returns, and vice versa. It is this category that is now unusually large—a bad sign.
The newsletter’s approach is quantitative, which means that it is immune to the sentiment extremes to which human beings are all too susceptible. That’s crucial, because we otherwise are likely to be too optimistic at bull market tops—just as we’re prone to be too pessimistic at market bottoms.
One of those bottoms in which pessimism was widespread came in the spring of 2020, which is the last time I wrote about this newsletter’s data. That was when the economy was slipping into the medically-induced coma due to the Covid-19 pandemic. Despite the doom and gloom then prevailing, the message of the Overvalued category was positive: The category was unusually small, smaller than at any time since 1984, in fact. Since that column appeared, the S&P 500 (with dividends) has risen 65%.
Today’s stock market isn’t quite as overvalued as it was undervalued in April 2020, but not by much. The Overvalued category then stood at the 15th percentile of the historical distribution, meaning that only 15% of prior readings back to the mid-1960s were any lower. The size of the Overvalued category today, in contrast, stands at the 75th percentile.
Going to Cash Isn’t Necessarily the Answer
Note that building up cash in your equity portfolio isn’t the only possible response to the oversized Overvalued category. Another possible response, one that Wright recommends, is to shift your portfolio towards undervalued dividend-paying blue-chip stocks. Lest you think that such stocks are stodgy and boring, let me report that the newsletter’s model portfolios have outperformed the stock market over the last 30 years.
This has been true this year as well, by the way. I devoted a column in January to Wright’s top-10 list, and since that column appeared, those 10 stocks have produced an average gain of 24.1% — in contrast to 20.8% for the S&P 500’s dividend-adjusted return.
Below is an updated list of the stocks on Wright’s list.
Old National Bancorp
Walgreens Boots Alliance